Bonds are considered as a secure investment option. They are less risky compared to equity and so risk averse people like to invest in bonds.
Bonds are issued either by companies or government to raise capital for funding their expenditure.
Apart from being a secured investment option, bonds also help you to diversify and grow money. So, bonds can be considered as a good medium for saving by investors.
Types of Bonds
Bonds are of two types:
1. Corporate Bonds.
2. Government Bonds.
Corporate bonds: Bonds that are issued by corporations to raise capital in order to fund their long term investment goals are considered as Corporate Bonds.
The bond holders get returns at specific intervals. These bonds being issued by corporations are safer than equity.
Again, Corporate bonds can be of two types:
1. Convertible Bonds.
2. Non-convertible Bonds.
Convertible bonds: Convertible bonds are issued by corporations which can be converted to specific number of equities at the discretion of the bond holders. They tend to offer a lower rate of interest as they can be traded in the stock market.
Non-convertible bonds: Non-convertible bonds are just bonds and cannot be converted into stocks. These bonds provide higher returns with a reduced risk.
Government Bonds: Bonds that are issued by the government are considered as government bonds. Government issue bonds to generate capitals that help in meeting expenditure.
Typically, in India the size of government bond market is greater than the size of the corporate bond market. Government bonds are considered secure and provide interest rate prevailing in the market.
Risk with bonds
Though bonds are considered safer than stock market as they are safeguarded from market fluctuations, they carry risks. The risks which are associated with the bond markets are:
1. Interest rate fluctuations - There is an inverse relation between interest rate and bond prices. That means, if interest rate falls then bond price rises and if interest rate rises then bond price falls.
2. Inflation - If you invest in bonds either for long term or for short term, then your returns can be wiped out by inflation. The CPI inflation rate tend to remain higher which will erode the return on bonds.
3. Default risk - Some corporate bonds carry default risk as they are not guaranteed by the government but depend on the corporation's ability to return the money they borrowed from investors.
4. Reinvestment risk - The investors have the risk of re-investing the bonds earning lower rate of interest than they were getting earlier.
5. Rating downgrade - If a credit rating of a company gets reduced then the lending institutions and banks can charge a higher interest rate for future loans. So, companies may not be able to fulfill debt requirement which may hurt the existing bond holders.
Click here to read how to calculate yield of a bond.
Bonds provide secured and stable income to investors and are more liquid. However, you should always compare the risk and return before investing in a bond.